Master this introductory material on the balance sheet in the 2016 Level I CFA Program curriculum to breeze through tougher concepts later
This is our third week of reviewing the Level I CFA Program Financial Statement material, following the introductory reading and income statement analysis last week.
We begin on our review of the Balance Sheet, reading 26 of the Level I CFA Program curriculum, this week. The balance sheet is not quite as talked about among investors as the income statement but is no less important. Understand how the balance sheet relates to the other two statements, especially how assets are depreciated and expensed.
Understanding the Balance Sheet
The Balance Sheet financial statement is different from the other statements in that it is a snapshot in time rather than a presentation of activity over the period. The Balance Sheet shows assets, liabilities and owner’s equity as of the last day in the reporting period.
Assets represent economic resources of the company, resources that can be used to generate cash or sales. Liabilities are current or future obligations of the company, representing an outflow of economic benefit. Owner’s equity represents the remaining assets or economic resources after all creditors (liabilities) are paid. This gives rise to the balancing of the Balance Sheet with Assets equaling liabilities and equity.
Assets and liabilities are presented in terms of liquidity. Assets that are highly liquid like cash or those that can be converted to cash are show first. Those liabilities that are expected to be paid within a year are shown first in short-term liabilities. The remaining assets and liabilities are shown in long-term accounts because they are expected to be used or paid out over more than a year.
Understand that some of the assets on the Balance Sheet will have a contra-asset and the difference between historical value and net. Accounts receivable is offset by the allowance for doubtful accounts for Net Receivables. Property, Plant and Equipment is offset by depreciation for its net value.
There is a lot of accounting concepts on the balance sheet but you must know them to be a good analyst. You’ll go into more detail on how inventories, long-term assets and other accounts are depreciated, expensed and recorded in other readings. If you don’t have a strong background in accounting, it’s imperative that you spend the time necessary to master this introductory material so you can understand the more detailed readings.
The differences between U.S. GAAP and IFRS reporting can be tedious and confusing. It’s best if you put together a table for each financial statement. Label the different accounting items (inventory, PP&E, etc) down the left-side column followed by columns for GAAP and IFRS. This makes for a quick review of the differences that you can use a few times a day until you’ve got them committed to memory.
An important distinction on the Balance Sheet is the classification of financial assets. Financial assets (liquid assets in stocks and other securities) are either classified as Held-to-Maturity, Held-for-Trading, or Available-for-Sale. How the asset is classified will affect how it’s value is recorded and how the gains/losses show through to the income statement.
- Held-to-Maturity assets are measured at amortised or historical costs and no unrealized gains/losses are reported.
- Held-for-Trading assets are recorded at fair value and marked to market with unrealized gains/losses recognized as profit/loss on the income statement and in retained earnings.
- Available-for-Sale assets are recorded at fair value with unrealized gain/loss recognized on Other Comprehensive Income and accumulated within owner’s equity.
Balance Sheet Analysis
As with the reading on the Income Statement, the analysis here is fairly light with just some ratios. The reading is focused more on the accounting concepts for the Balance Sheet while other readings will go deeper into the analysis.
In ratio analysis, you must remember to adjust your Balance Sheet numbers when using them with numbers from the other financial statements. It’s easier than it sounds, you just need to take the average of the beginning and ending values for the Balance Sheet number.
For example, the Days Sales Outstanding ratio is found by taking the average of the beginning and ending receivables on the balance sheet and then dividing by sales or credit sales from the income statement.
Make sure you understand and remember the liquidity ratios and the solvency ratios. These are very basic and will be used throughout the CFA exams and your job as an analyst.
Liquidity Ratios: Current, Quick (acid-test), Cash
Solvency Ratios: Long-term Debt to Equity, Debt to Equity, Financial Leverage
We’ll continue with the Statement of Cash Flows next week and then a week for financial statement analysis. Make sure you are scheduling enough study time to read through the curriculum, work practice problems and then review study notes. It’s only this repetitive system of studying that will allow you to commit the material to memory.
‘til next time, happy studying
Joseph Hogue, CFA